A Valuable U.S. Export: Banking Regulations

Feb. 18 (Bloomberg) -- By this point in the economic
recovery, the biggest U.S. banks had expected the pressure from
regulators to abate. In the aftermath of a major financial
crisis, there is usually a turn toward tighter rules, and banks
naturally build up their equity buffers after near-death
experiences.

It is standard practice, at this point in the credit cycle,
for bank advocates to claim that a great deal has changed, that
banks have more equity capital than at any time in recent memory
and that governments need to ease up on the rules if they want
credit to expand and growth to take hold.

This is exactly what leading representatives of global
megabanks now say. And there are indications that European
regulators are listening, as France, Germany and other nations
back away from previously promised reforms.

In the U.S., however, there are signs that official
thinking is pushing in the opposite direction, in particular
toward requiring larger buffers of loss-absorbing equity.

Republican Voices

The most recent signal that the U.S. may be on this path is
a recent speech by Jeremiah Norton, a member of the board of
directors at Federal Deposit Insurance Corp. Norton, a
Republican appointee with Treasury and Wall Street experience,
joins other important conservative voices in expressing
skepticism about the U.S.’s banking arrangements. (These voices
include former Utah governor and presidential contender Jon
Huntsman, Federal Reserve Bank of Dallas President Richard
Fisher, FDIC Vice Chairman Thomas Hoenig, and the newspaper
columnists George Will and Peggy Noonan.)

Specifically, Norton asks whether the U.S. should continue
to rely heavily on sophisticated risk-based measures of assets
to calculate the adequacy of what is known as “regulatory
capital ratios.” Or, instead, should greater emphasis be placed
on the simpler, more straightforward measure of “leverage” --
meaning how much equity a bank has relative to its assets,
without any risk adjustments (or, equivalently, how much debt
versus equity the company has on the liabilities side of its
balance sheet)?

Norton prefers to focus on leverage, which is simpler to
assess and easier to monitor. Risk weights are always wrong,
often with dire consequences, as we saw with mortgage-backed
securities, collateralized-debt obligations or Greek sovereign
debt. During the 2007-08 financial crisis, Norton said, “the
markets rejected the existing Basel risk-based capital
measurements in determining a bank’s likelihood of default.” Yet
the latest evidence suggests the banks are again “optimizing”
their capital, essentially gaming the rules to be able to take
on more risk.

The FDIC director also insists that the right measure of
capital is equity -- built up through retained earnings and by
raising cash from shareholders -- and not a more complex
concept, such as tax-deferred assets. And he thinks banks should
have significantly more equity relative to their debts than is
currently planned under the Basel III international agreement.

He will find ample support for these positions in “The
Bankers’ New Clothes: What’s Wrong With Banking and What to Do
About it,” by Anat Admati and Martin Hellwig. This book is a
must-read for anyone interested in finance or concerned about
economic policy (excerpts were recently published by Bloomberg
View).

Banks’ Losses

Admati and Hellwig have written a powerful explanation of
why banks like to borrow too much: It allows them to increase
return on equity (unadjusted for risk) in good times, and
someone else has to worry about the losses in bad times. Deposit
insurance distorts incentives, creating the need for tough rules
for institutions with retail deposits. Those rules, overseen by
Norton and his colleagues at the FDIC, have generally worked
well since the 1930s.

Unfortunately, today’s “too-big-to-fail” implicit downside
guarantees for the banks are much more dangerous. The banking
lobby denies this safety net exists, even though it is
completely obvious to anyone in the credit markets. This is a
form of government-provided insurance, for which no premium is
charged. It distorts the marketplace and is fundamentally unfair
to smaller competitors.

The banks involved are very large relative to the economy,
and if any were to act irresponsibly, there could be
macroeconomic consequences. And even if the downside losses are
limited in a narrow financial sense -- for example, because the
new FDIC-run resolution authority proves effective -- there can
still be catastrophic implications for growth, employment, the
federal budget and much else.

With the U.S. rapidly becoming a bastion of more sensible
official thinking, and the Europeans moving in the opposite
direction, to what extent should countries aim to cooperate and
to coordinate capital standards?

Andrew Haldane, the executive director for financial
stability at the Bank of England, suggests that we should think
of financial systemic risk as a form of pollution. It makes
sense to seek international agreements to limit pollution. After
all, smog knows no boundaries. But if countries on the other
side of the world insist on breathing foul air, should the U.S.
do the same? Of course not: It should set rules that serve its
interests.

In other words, if other countries want to allow dangerous
forms of finance, the U.S. should first try to talk them out of
it, and then rapidly head in the opposite direction.

(Simon Johnson, a professor at the MIT Sloan School of
Management as well as a senior fellow at the Peterson Institute
for International Economics, is co-author of “White House
Burning: The Founding Fathers, Our National Debt, and Why It
Matters to You.” The opinions expressed are his own.)